Going Way Beyond Price

Instead Of Poring Over Listings, Warren Buffett Does Behind-the-prices Research And Stocks Up On Firms That Put Shareholders First When Allocating Capital

February 26, 1995|By New York Times News Service.

Do you study the stock market? Do you puzzle over interest rates? Do you plumb the depths of modern portfolio theory?

No doubt you hope to profit from your hard work. Well, here's some disturbing news. Warren E. Buffett, the investing phenomenon whose Omaha holding company, Berkshire Hathaway, was trading at Friday's close at an eye-popping $22,550 a share, does none of these things.

Buffett has said, "As far as I am concerned, the stock market doesn't exist." He has said, "If Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, I wouldn't change a thing." He has even said, "Lethargy bordering on sloth remains the cornerstone of our investment style."

What Buffett does with his time is look long and hard at the companies, the businesses, behind the stocks. Experts spend much time debating if he still hews to the "value," or bargain-hunting, approach of his mentor, Benjamin Graham.

But for Buffett, whose company had compounded average annual returns of 23.2 percent from 1965 through 1993, that issue is beside the point. "The nine most important words ever written about investing," he has said, are Graham's adage, "Investing is most intelligent when it is most businesslike."

But what does that phrase mean? Drooling investors want to know.

"The Warren Buffett Way," the current best seller written by Robert G. Hagstrom Jr., a Philadelphia money manager, and published by John Wiley & Sons, describes well how Buffett grades businesses.

The highest marks, Hagstrom writes, go to managers who put shareholders first when allocating capital.

Managers with good rates of return should plow cash back into their companies to get more good returns, Buffett believes. But if returns are average or worse, reinvestment makes no sense.

Even though companies may hope that their luck will turn or that an acquisition will make the difference, he says, most underperformers should return extra cash to shareholders, who can then seek higher returns elsewhere.

Managers who do so, through increased dividends or stock buybacks, tend to be low on ego and high on shareholder interests, he believes.

Berkshire Hathaway has invested in many such enterprises. A hallmark of its holdings are companies that have done stock buybacks, reducing the shares outstanding and raising their value.

Capital Cities/ABC, in which Berkshire has a $1.7 billion stake, bought back nearly 2 million of its 18 million outstanding shares between 1988 and 1992. Other Berkshire holdings that are big on buybacks are Washington Post Co., Geico and PNC Bank.

Buffett also likes businesses that are shielded from competition and thus can earn higher profits. And these ventures include more than just his well-known brand holdings such as Coca-Cola and Gillette.

Geico, for instance, has carved out an insurance franchise with a simple idea: It finds a group of statistically safe drivers-such as government employees-and sells them auto insurance by mail.

Using the mail cuts out agent commissions and makes low-priced policies possible, while the chosen pool of drivers keeps costly claims down. No insurer does exactly what Geico does, and Buffett knows it. The company is his third-largest holding.

Then come low costs. Berkshire, with 11 employees and no legal or press offices, keeps overhead at less than 1 percent of operating earnings. If it were 10 percent, Buffett has said, returns would drop 9 percentage points.

Buffett's holdings are equally parsimonious. Even when Geico became the nation's seventh-largest insurer, Hagstrom says, its chief executive still shared a secretary with two other managers.

And it "warmed my heart," Buffett said, to learn that executives at H.H. Brown Shoe Co., another Berkshire holding, get a base salary of just $7,800 a year. The rest comes from profits-if there are any.

Buffett asks other business questions: Can the industry's earnings grow without great outlays? Are the managers impressive? And, of course, is the stock cheap?

And is the business understandable? Despite high regard for Microsoft, for example, Buffett avoids its stock because the field puzzles him. Ignorance, he says, increases danger.

This belief is a departure from the common wisdom about stock diversification. Owning many different stocks-good, bad and mediocre-depresses the returns that a more selective portfolio would achieve, he believes, and makes it impossible to understand all that you own.

Thus, in 1987, his $2 billion portfolio had just three companies. Today, nearly $15 billion is spread among just 10.

Buffett is not the only investor to recognize that the business behind a stock is the important factor in the long term. But he is rare in remaining deaf to the roars of Wall Street. He has no stock-quote machine in his office, for example, and he describes the market as a slough of fear and greed untethered to corporate realities.

As Hagstrom writes: "When Buffett invests, he sees a business. Most investors see only a stock price."